Quick Thoughts on Modern Monetary Theory

Written by Dean Baker

Saturday, 25 February 2012 13:47

Since there were many thoughtful comments on my earlier post, it seemed worth saying a bit more by way of response. As I noted at the onset, I did not see a difference between MMT and the Keynes that I first studied more than 30 years ago. I guess I still don’t see the difference.

In my prior post I noted that there were three channels to raise the economy back towards its potential:

Government spending and tax cuts;

Expansionary monetary policy; and

Devaluing the dollar to increase net exports.

I should also add a fourth channel that can move the economy to full employment by reducing the average workweek or work year: work sharing.

As best I can tell, the MMT folks would have us only use the first channel and seem to disparage the other three routes to raising employment levels. I will briefly argue the merits of the other three channels and explain why I do not think reliance exclusively on the first channel is the best policy.

The Monetary Policy Channel

Several comments on my earlier post argued that monetary policy alone could not be counted on to get the economy back to full employment. This is true, but of course not what I was arguing.

I was making the case that the Fed can do more to boost the economy, even with short-term rates near zero. It could target a longer term rate, for example committing itself to push the 5-year Treasury rate to 1.0 percent or the 10-year Treasury rate to 1.5 percent.

This would boost the economy in several ways. First, investment is relatively unresponsive to interest rates, but it is not altogether unresponsive. In other words, with sharply lower interest rates, we should expect to see some additional private sector investment.

We should also see money freed up from mortgage refinancing. This amounts to a shift of income flows from creditors to debtors. That should lead to some additional consumption under the assumption that the propensity to consume for people with mortgages is somewhat greater than the propensity to consume among people who own mortgages or mortgage backed securities. (Many people have over-estimated this effect, but it certainly is not zero. If we can get $4 trillion in mortgages refinanced at interest rates that average 1.5 percentage points less than their prior mortgage, it would reduce annual payments by $60 billion. If we assume that one third of this translates into additional consumption, it amounts to $20 billion a year in added demand. )

There is also the potential for higher inflation, especially if the Fed explicitly targets a higher rate of inflation as several economists (e.g. Krugman and Bernanke) have argued. A higher rate of inflation should both induce more investment by lowering the real interest rate and also reduce the real debt burden for homeowners, young workers with outstanding student loans, and other borrowers.

I can see no reason why we would not want the Fed to push the monetary channel as far as possible. There is no obvious downside and considerable potential benefit.

A Lower Valued Dollar

Another benefit from more expansionary monetary policy is a decline in the value of the dollar, which would have the benefit of boosting net exports. Here too I fail to understand the nature of the objections of the MMT crew. Certainly the United States can run large trade deficits for periods of time, but this does have real consequences. If we assume that other countries will not subsidize our consumption indefinitely, then we will at some point have to adjust to a world in which we have some semblance of balanced trade.

I don’t see how we can think that going from large deficits (e.g. the 6 percent of GDP we ran in 2006) to balanced trade can be painless. Industries do not just spring up overnight. The process of adjustment will inevitably mean some inflation and reduction in living standards, as the goods that we used to get cheaply from abroad will be replaced by higher priced domestically produced goods.

To see this point, imagine a more extreme case. Suppose that we had a trade deficit equal to 50 percent of GDP. If the countries who were buying up dollar assets then decided that they had enough, so we could no longer rely on imports to meet half of our domestic demand, does anyone believe that the U.S. economy could quickly and painlessly replace our imports with domestic production?

I would not attribute this view to the MMTers, but then the question becomes one of a degree. Perhaps a trade deficit of 6 percent of GDP is okay, but presumably somewhere between 6 percent and 50 percent we get into a problem. It seems the question then has to be how quickly the U.S. economy could adjust to a much lower trade deficit and what is the risk that foreign countries will slow or stop their purchases of U.S. assets? We may differ on the answer to these questions, but they are the questions that must be asked.

Note that the reduction in living standards in this story is relative to a scenario in which the trade deficit does not change. It does not mean an absolute reduction in living standards since even a large increase in import prices can easily be more than offset by increases in productivity growth. For example, if the price of the 16 percent of GDP that we currently import rises by 20 percent (a huge increase) over three years, this would effectively reduce living standards by 3.2 percent, other things equal. If this increase takes place over three years, that translates into a decline of just over 1.0 percentage point a year, less than half the 2.5 percent average rate of productivity growth over the last 15 years.

Also the rising price of imports would not affect everyone equally. Those who most directly compete with imports in their work (i.e. manufacturing workers) would see wage gains that would almost certainly far outstrip the effect of higher import prices.

To see this, imagine that we deported half of our doctors tomorrow. This would send the price of health care soaring as doctors might see their pay double or even triple. The remaining doctors would have to pay more for their health care in this story like everyone else, but they would still see an enormous rise in their standard of living. It is the same story for manufacturing workers and those who could be manufacturing workers (e.g. workers without college degrees more generally) when the dollar falls making imports more expensive. They would see sharp rises in their wage would far outstrip the impact of paying more for the goods that used to be imported.

The decline in living standards in this story would primarily be felt by people who are largely protected from import competition at present (e.g. doctors, lawyers, policy wonks). The class distribution of gains and losses is likely a large part of the explanation for why a lower valued dollar does not feature more prominently in policy debates.

By the way, there were some comments to the effect that we would have to lower our standard of living to Chinese levels to improve our trade balance with them. This is wrong. Our standard of living is determined primarily by our level of productivity. If the value of the dollar relative to China’s currency fell to the point where our goods were more generally competitive, it would simply mean that we pay more for the goods we import from China. There is no mechanism through which this would cause us to have Chinese level living standards.

Of course a rebalancing of trade need not have any negative effect on national living standards even in the short-term if it is in the context of an economy that is operating well below its potential. In that case, the increase in output associated with increased net exports would easily swamp the effect of rising import prices. (Imagine GDP rose by 6 percent due to the increase in net exports associated with a lower valued dollar.)

There is one final point on this issue that is worth mentioning. It is common to refer to the devaluation strategy as a “beggar thy neighbor” policy. It is important to remember how the alleged beggaring works in this story. We are making our neighbors buy more of their own goods rather than selling them to us. The premise here is that the world is suffering from too little demand and that no one knows how to get anyone to buy their stuff so all they can do is to sell it other countries.

Of course the argument that we can always create more demand through deficit spending applies to other countries as well. The countries that currently have large trade surpluses could absorb these surpluses with more domestic demand. This should not be painful in principle, it means consuming more.

By contrast, to say that actions to reduce the U.S. trade deficit always involve beggar thy neighbor policy seems bizarre on its face. Is any deficit that we happen to run somehow the right deficit? In the case where our trade deficit is 50 percent of GDP, would we be beggaring our neighbors if we tried to reduce it to 40 percent of GDP?

There is actually a simple neo-classical story about what trade deficits should look like. In the old days (before the U.S. started doing the opposite in a big way), mainstream economists used to teach that rich countries should have trade surpluses with developing countries. This meant that the rich countries, who had lots of capital, exported capital to poor countries that had little capital. To put it another way, this meant that capital flowed from slow growing rich countries, where it got relatively low returns, to fast growing poor countries where it could get much higher returns.

The world has rarely worked this way for a variety of reasons, but there is a fundamental logic to this view. Poor countries need to both raise the living standards of their populations so that everyone can enjoy a decent life and also build up their infrastructure, capital stock and level of education. In principle, this process would be much easier if they are able to borrow from wealthy countries. The reality is that successful developing countries have generally not been large importers of capital, but that is a major failing of the international financial system, not something to be applauded. In a well working international financial system, China should not be lending capital to the United States.

Work Sharing as a Route to Full Employment

In my original comments I did not mention work sharing, but it really should be included in any discussion of full employment policies. There is nothing natural about the current length of work weeks and work years. They are the result of a set of historical processes and policy decisions which could well have been otherwise. In Western Europe, the standard work year for full time workers is around 20 percent shorter than in the United States.

All countries in the European Union must guarantee workers at least 4 weeks a year of vacation and many require 5 or 6 weeks. France has a 35 work week. All of them have paid sick days and paid parental leave. The United States could have gone this route if our politics had followed a somewhat different path over the last three decades.

Policy has also not been neutral on this issue. Our tax code hugely subsidizes employer provided health insurance. This is a large overhead cost that generally varies little with hours worked. As a result, employers would rather work the same worker more hours, even paying an overtime premium, than hire on additional workers and pay their health care costs. Therefore the government gave employers a direct interest in resisting shorter workweeks or work years.

In this context, it is difficult to see why we should not look to meet a shortfall in demand in part by encouraging employers to reduce work hours. The government already subsidizes layoffs through unemployment insurance. What can be the logic in saying that the government will pay half wages for workers who have lost their jobs, but not compensate for lower pay due to a reduction in work hours?

There are strong arguments that it is better for workers, employers and the economy as a whole to keep a worker on the job where they can be continually upgrading their skills rather than risk the possibility that they endure a long period of unemployment. This is a well-researched topic. The long-term unemployed have great difficulty finding new jobs and many will never be re-employed. If we have a route to avoid this risk, why would we not take it?

If it ends up being the case that increased use of work sharing leads to changes in the standard work week or work year, that would be great in my view. This would lead to more family friendly work places and likely better lives. The basic point would be that workers would be getting the benefits of increased productivity growth partly in the form of more leisure, not just higher income. (This assumes that we can restructure the economy so that workers do get the benefits of productivity growth.) Also, this should be great news for the environment. There is a very solid correlation between income and greenhouse gas emissions []. If people can get more time off in lieu of higher take home pay, it would be a relatively painless way to reduce greenhouse gas emissions.

Pitfalls of Going Solo: Problems of Relying Exclusively on the Government Channel

There is no dispute between MMTers and more traditional Keynesians like myself that increased spending and tax cuts can be an effective way to boost demand in a downturn. The question is whether this should be the exclusive route. I have argued above that we should also look to alternative channels to boost demand and work sharing to lower unemployment. Part of the reason is that I see no good reason not to push these alternative channels, however I also do see problems with relying exclusively on the government channel.

One of the problems is the potential for creating large structural imbalances that could be difficult to correct, as noted in the case of large trade deficits. But there are other reasons why exclusive reliance on the government channel may not be the best route.

First, if we go the spending route, there is a risk that some of the spending will be wasteful. This is both an economic concern and a political one. From an economic standpoint, we should always want our spending to be done in the most useful possible way. In the context where the alternative is just wasting resources by having workers and capital sit idle, then paying workers to dig holes and fill them up again would be an improvement, but we should hope to do better. Rushing huge amounts of spending into ill-conceived projects is not likely to be the best use of funds.

This also raises the obvious political issue that bungled projects make great stories for the political opponents of economic stimulus. We will be hearing much about Solyndra in the months and years ahead. It is worth taking political risks when there are clear policy gains from going a specific route, but if it is not necessary, why do it?

Alternatively, we can go the tax cut route. There is little doubt that if we have big enough tax cuts that we will eventually prompt enough consumption to bring the economy back to something resembling full employment. However, this does raise the risk that at some point when housing has recovered, the additional consumption from the tax cut will lead to a real problem of excess demand leading to inflation. I know the MMT answer is then to raise taxes, but I am not confident that this can always be done so easily.

Politicians are not generally eager to raise taxes. If we create a situation in which we are counting on big tax increases to prevent inflation, then we run a real risk that inflation could become a big problem, especially if we have been very loose with our monetary policy.

As a practical matter, I know that inflationary concerns in the U.S. economy have been vastly overblown. Only twice in the last half century (the late 60s and the 70s) is there a plausible case for inflation having been a problem and in both cases there were highly unusual extenuating circumstances (the Vietnam War and the surge in oil prices following the Iranian Revolution). Nonetheless, we have also never had a prolonged period of large budget deficits. There can be little doubt that we can run large enough budget deficits to cause inflation, especially if monetary policy is accommodating.

When we get to the world where we are raising taxes then we have to be concrete in terms of whose taxes get raised and by how much. This obviously raises many difficult political questions, including the extent to which we would substitute cutbacks in government spending. Suddenly we are in the world of tradeoffs between taxes and spending in which Washington is endlessly mired. I have spent as much time as anyone yelling about the need to boost demand and to restore full employment, but assuming we do at some point accomplish this goal, I don’t see how MMT gets us around the world of budget constraints that the honchos in Washington think we are in now.

I’ll conclude with a final point about my own reluctance to formally embrace MMT (which I don’t see as different from Keynes). I have long realized that in Washington policy debates who says something is far more important than what is being said.

We see evidence of this all the time. Witness the incredible sycophantism that surrounded Alan Greenspan before the collapse of the housing bubble. Note that the list of people engaged in Greenspan worship included not just Washington politicians and the top economic reporters at the Washington Post, Wall Street Journal and elsewhere, but even many of the world’s most prominent economists. The 2005 Jackson Hole meeting of central bankers was devoted to a Greenspan retrospective where they debated whether he was the greatest central banker of all time. In short, people who certainly should be able to think for themselves generally don’t.

I recall an extreme version of this back in the debate over privatizing Social Security. I made what should have been a fairly simple point: it was impossible to get 7 percent real returns in a stock market with a price to earnings ratio well over 20 and a projected real growth rate of 2.0 percent. This was simple arithmetic, but all the big names in economics, including the non-partisan professionals at the Congressional Budget Office and the Social Security administration continued to write 7.0 percent real returns into their projections.

We were finally able to score some points on this issue with the “No Economist Left Behind” test, which asked economists to write out a set of dividend yields and capital gains that added to a 7 percent real return. (in other words, they had to write down two numbers that added to 7.) Using the Social Security trustees profit growth projections, 7 percent real returns would have required either paying more than 100 percent of profits out as dividends or having price to earnings ratios of 300-400. However, even our limited success in this case (no one in a position of authority acknowledged their error) was only accomplished after Paul Krugman wrote about the issue in his NYT column and the no economist left behind test caught fire in the blogosphere.

My point here is that anyone challenging the status quo is almost completely excluded from public debate. This was third grade arithmetic – the bad guys were just simply wrong – and we could not get people like the Washington Post editorial board and columnists to recognize this simple fact.

If we can’t win a debate on arithmetic, how can we think we will get people in policy positions to accept that their conceptual framework is wrong? For my part, I want to take every opportunity (and there are many) to show that the people in authority have gotten their arithmetic wrong. Rather than trying to challenge their theories of the world, I am going to point out that they will not apply them consistently.

You want free trade – let’s remove the trade barriers that protect highly paid professionals like doctors and lawyers. How about eliminating protectionist barriers like copyrights and patents that drain hundreds of billions of dollars out of the economy each year and, also redistribute income upward? Let’s let all banks compete in a free market instead of giving some too big to fail insurance from the government. And, how about making banks follow the same laws as the rest of us when they file legal actions, like foreclosure?

I don’t see much hope of winning an argument about what sort of monetary theory the Fed should be applying. However, I think there is real political potential in showing that the people running economic policy seem to not understand arithmetic. And since they are willing to oblige us with so many examples where their arithmetic failures have real and demonstrable consequences, it would be a shame not to use them.